First, don't panic. If you're reading this article during a market crash or are worried about one, you're probably wondering, “now that stock prices are plummeting and everything is going to hell, how should I change my investment strategy to avoid further losses? Should I take all my money and hide it under my mattress?”
It's incredibly difficult to watch your long-term investments, many of which make up individual retirement funds like a 401K or IRA, college funds for future or young children, or down payments on larger purchases such as a home, drop in value. Our natural first instincts are to quickly withdraw as much money as possible to try to avoid any further losses.
But despite this gut reaction, it's been proven time and time again that you're much smarter to avoid such radical action.
It's important to recognize, especially in turbulent financial times such as these, that the best financial practices are mostly the same as they were six months ago:
- Build up a strong emergency fund
- Create and follow a monthly budget with an ideal savings rate of 20%, and
- Have a well-diversified investment portfolio.
We'll discuss each of these practices in greater depth and explain our reasons for supporting them below. The short answer to the original question is: unless you were previously engaging in very high-risk investment practices, don't go making any drastic changes to your portfolio or savings strategy.
Are we in an economic recession? A depression?
Before proceeding any further, we want to address some of the terms you may have heard thrown around in the past couple of days, either in casual conversations or on major news outlets. Words like “recession” and “depression” can elicit a lot of fear from the general public, but knowing what these terms mean provides you with a more accurate picture of our current situation.
What is a recession? An economic recession is usually defined as a significant economic decline, reflected in factors like the unemployment rate and real GDP, that continues over the course of several months (at a minimum of two quarters, which translates to six months).
While the past month or so has certainly been unpleasant and maybe downright painful, to say we are in a recession is too premature. The current drop in our market would need to continue for several more months before we could begin calling this a recession.
What about an economic depression? An economic depression would be like a recession on steroids. It involves a much steeper economic decline that continues for at least three years and is incredibly rare in the US. Simply put, we are currently a very long way off from being in an economic depression.
Even if you think back to the ‘Great Recession' that started in 2008, it did not qualify as an economic depression.
So what should I do?
It may seem counterintuitive, but the best things you can do in times of economic distress are the same as what you would do during economic prosperity (that's part of what makes them the best — they're consistent). Let's go back to our basic financial practices:
Building up a strong emergency fund
First, we recommend building up a $1,000 emergency fund and storing it in a standard savings or checking account, which is insured by the federal government up to $250,000. We like to keep ours in a high-interest savings account. This fund can help you in the event of an unexpected expense (medical emergencies, home & auto repairs, brief periods of unemployment, etc.) and prevents you from needing to turn to predatory lending services like payday loans in moments of financial crisis.
After you've built up your $1,000 emergency fund, you should contribute to your 401(k) until you've met the full contributions of any employer-match program (many companies may match ½ of everything you put in up to a certain percentage ie. if you put in 4% of your salary, your employer will contribute an extra 2%).
This is so important because, regardless of whether your employer matches ½ vs the full value of your contributions, you're earning incredible returns on your money!
If you have any credit card debt or other high-interest debt (over 8% per year), you should first pay that off. Otherwise, this is when you should build up a more substantial emergency fund. We usually recommend saving enough money to cover 3-6 months of basic needs (food, water, shelter) so that in the event of a more serious medical emergency or longer period of unemployment, you are still able to pay your bills and have a place to live.
Creating a monthly budget
Though your monthly expenses may look different depending on how COVID-19 has affected your area, — for example, residents of California are likely spending more on food and daily supplies but less on transportation given the recent lockdown — the core principles underlying healthy budgetary practices remain the same.
Create a realistic budget that includes all of your regular monthly expenses using bank statements, credit reports, and receipts. Then, calculate your income including after-tax salary / wages, any side gigs, current dividends paid from investments, or self-owned businesses. Once you've figured out your income and your expenses, it's time to categorize your expenses as either “must-have,” “priority but non-essential,” and “wants / luxuries.” It's important first to cover your “must have” expenses, including things like food, electricity and water, and rent, and then move on to your savings goals.
Your savings goals should make up at least 15% of your total income and include building up your emergency funds, paying off debt, and investing in your 401(k) and IRAs.
After you've met your savings and investment goals, it's time to meet your “priority but non-essential” expenses, which will likely look different from person to person. From here, use whatever money may be left to decide which wants and luxuries you want to budget into your life.
One of the most critical factors in investing and the thing that separates wise investing from glorified gambling is diversification. By creating a well-diversified portfolio, you can help mitigate any potential effects of a market decline. So how can you check your own portfolios and get a sense of how healthy your asset allocation is? Well, in addition to speaking with a tax professional, there are a few things you can do examine even if your knowledge is more limited:
Make sure your portfolio is balanced across types of assets. This means holding a good mix of stocks and bonds, but what constitutes “good” will depend on your risk tolerance. As general rules of thumb, stocks are considered riskier than bonds and tend to yield higher returns than bonds.
Decide on your asset allocation regardless of how you think the market will move.
If you're younger than 35, we recommend a healthy balance of 80% stocks / 20% bonds in your portfolio. If you're above 35, we recommend you start gradually moving closer to a ratio of 70% stocks / 30% bonds. For those of you who may already be retired, a conservative ratio would be 50/50 stocks and bonds.
The reason this ratio changes with age is that if you're investing at, say 30, and you won't need the money for the next 30 years, you can invest more in stocks because they have higher rates of return and aren't very volatile over the course of decades. If you are instead investing with money you'll need five years from now, you likely want to be more conservative since there will be less time for you to recoup any future losses.
The other type of balance to be aware of is balancing stocks across industries or sectors. The idea here is avoiding having too many assets tied up in a single industry, such as technology, health care, automobiles, or any single type of asset. The dangers of ignoring this advice can be seen in both the 2008 financial crisis, where large amounts of money were all tied to homes which led to large amounts of volatility when house prices fell, and the early 2000's, when large amounts of money were tied to Internet-based companies.
Forget About Picking Individual Stocks
It can be difficult to choose individual stocks in a way that minimizes risk, which is why we advocate for the use of ETFs and mutual funds. These two assets often include pre-built collections of well-diversified stocks and bonds and thus can really ease the process of diversification.
You can even take advantage of Target Date mutual funds which not only have a diverse selection of stocks and bonds, but they also automatically adjust the ratio of stocks to bonds over time. This means you don't have to worry about adjusting your portfolio as you age and get closer to retirement.
When selecting ETFs and mutual funds, you should look and see the breakdowns of stocks and bonds within each fund. This is where you can try to balance across industries — if all of your mutual funds have the bulk of their stocks in tech companies (Apple, Google, Facebook, etc), you may want to consider moving some of your investments into mutual funds that hold more assets in other industries to limit your exposure to individual sectors.
Things to avoid (What NOT to do)
Now that we've outlined the basics of what you should be doing, let's quickly go through a couple of practices and discuss why they're examples of what NOT to do:
Liquidating all assets and waiting (the “hide it in a safe under my mattress” method)
This “strategy” is many people's first thought whenever they see significant drops in stock prices. It's understandable why someone would think to do this: they just checked their balance and saw a lot less money than there was a few months ago, so better to try to stop any further losses, right?
Well, there are three main flaws with this plan: it's impossible to time the market, there may be tax ramifications that can cost even more of your money, and it can make the broader economic situation worse.
It's impossible to time the market. This is a simple fact of life. You can certainly get lucky by trying to do it. But over the long-run, you will never beat the market average by trying to time it. The closest approximation some individuals have to truly “beating the market” is to use illegally-obtained information about a company's actions to invest accordingly (this is called “insider trading”).
Nobody can know what the stock market will do tomorrow, and if you withdrew all of your money right before the market started recovering, you might've just lost out on recuperating some of those earlier losses. Remember: investing is safest when done over long periods of time, so hang tight. Your future self will thank you for it.
Second, if you run and liquidate all of your investments, you could be subject to significant tax liabilities thanks to the capital gains tax. Depending on the type of account your investments are in, such as a Traditional IRA, you may also face additional fees and penalties if you withdraw your money early. There's no need to throw away money.
Third, public panic can slow down economic recovery and make the situation worse. A similar effect was observed during the Great Depression in the 1930's, when many households were reluctant to spend or invest any money for fear of permanently losing it. This, in turn, made it much more difficult for businesses to operate and slowed the process of economic recovery. Think of keeping calm as the “social distancing” equivalent of keeping the economy healthy.
Investing large amounts of money on-margin
Remember those high-risk investment practices we mentioned at the top of this article? Investing large amounts of money on-margin, which basically translates to “using borrowed money,” would fall into that category. This is because borrowing money to invest increases your portfolio's volatility, so it gains more during periods of economic growth but loses more during economic decline.
It's essentially the high-stakes version of normal investing, and in times of uncertainty, we greatly prefer sticking to safer investment practices.
A Final Thought
We wanted to leave you with some final thoughts from professional investor Warren Buffet: “Don't panic about the virus … I don't think it should affect what you do in stocks.” So there you have it: don't just listen to us, listen to one of the world's most successful long-term investors and one of the wealthiest people in the world.
Lucas is a personal finance expert, an undergraduate student at Harvard University and the founder of the Personal Finance and Consulting Group at Harvard College (an officially recognized student organization). He has spent much of his life working to increase financial literacy in his surrounding communities through independent financial research and curricula design, and he is currently studying economics with a secondary in music.